Coag said progress was being made in just eight out of 22 educational benchmarks, with four showing noticeable decline in the five years to 2012. Photograph: Dan Peled/AAP

A lost generation of disadvantaged young people not engaged in work or study have been warned they could face a "life sentence of poverty and exclusion" in light of a government report that finds vast discrepancies in educational achievement based on wealth. The Council of Australian Governments (Coag) reform council education report found widespread stagnation in literacy and numeracy skills among secondary school children, warning that students below the national minimum standard are "at risk of being left behind". In years 7 and 9, children in the lowest socio-economic group experienced a decline in reading standards between 2008 and 2012, with "large gaps" in achievement at all levels between the richest and poorest students. In the report's main findings:

• 41% of disadvantaged young people are not engaged in work or study after leaving school, with the gap between them and wealthier students widening since 2006.• Year 12 attainment for the most disadvantaged students is 20% lower than the highest socio-economic group – a similar gap to 2006.

• Overall, 27.3% of people aged 17 to 24 aren't engaged in work or study following school – an increase from 26.1% in 2006. While the number of young people in full-time study increased, this hasn't offset a significant dip in full-time employment levels. The prospects for Indigenous students appear particularly stark, with 60.6% not fully engaged in work or study after school, compared to 26% of non-Indigenous people. The report states: "Indigenous children are more than twice as likely to start school developmentally vulnerable. There were no improvements in Indigenous school attendance over five years, with decreases in some years.

"Indigenous students are much less likely to meet the minimum standards in reading and numeracy. In five years nationally, only year 3 reading improved but year 3 and 7 numeracy declined."

In its report card, which will be delivered to state and federal governments, the Coag reform council said progress was being made in just eight out of 22 educational benchmarks, with four showing a noticeable decline over the five years to 2012.

Nationally, 85% of young people completed year 12 in 2011, up from 80.8% in 2006, although a Coag target of 90% completion by 2015 is unlikely to be achieved.

There were "significant increases" in year 3 and year 5 reading and year 5 numeracy scores, according to the report, with a strengthening uptake of pre-school programs expected to reap benefits over the coming years.

However, encouraging signs at primary school level, and the improved year 12 achievement rate, are tempered by a flat line, and even decline, in secondary school benchmarks.

The report states Australia "falls short" of top-performing nations, with the proportion of students advanced in reading, maths and science "well below" countries such as Singapore.

In year 4 science, Australia's performance regressed from 10% at the advanced benchmark in 2007 to 7% in 2011.

The report, a half-time progress update on 10-year educational goals agreed to by the states, presents a series of challenges for the new Coalition government, which has committed to following Labor's Better Schools/Gonski education plan, which calls for increased funding aimed at disadvantaged students.

In a letter to Tony Abbott, the former Victorian premier John Brumby, who chaired the Coag council, said tackling educational disadvantage experienced by Indigenous and disadvantaged people "remains a big challenge".

"The education outcomes for these groups are still poor," Brumby wrote. "Large gaps in reading and numeracy achievement remain in place."

Tony Nicholson, executive director of anti-poverty group Brotherhood of St Laurence, told Guardian Australia the results were "disappointing and frustrating". "It's particularly frustrating because we know the modern economy places a real premium on qualifications and skills," he said. "For many of the young people we work with on a daily basis, this essentially means a life sentence of poverty and exclusion because they don't have the qualifications they need. "This report shows that despite a welcome increase in the number of people with qualifications, significant numbers of young people don't have basic numeracy or literacy. They won't be able to get work, which will be a huge problem for them and also our economy as our population ages." Nicholson said funding that should help disadvantaged young people had, to date, been poorly administered. "We have to start seeing students in an holistic way – if they are having problems at home or come from a refugee background that has no experience of a conventional school, that is going to impact their achievement level," he said. "We can identify children in years 7 and 8 at risk of dropping out of school. We need to target resources to them in the right way, not just through teaching but also welfare support staff. The Gonski funding is very welcome, but we won't see much improvement if the money just goes to overall school expenditure." Lisa O'Brien, chief executive of education support charity the Smith Family, said the report made "incredibly worrying" reading. "If young Australians aren't achieving at school they are less likely to participate in broader society and we'll see problems in our justice system, among other things," she said. "Too many kids we work with grow up not knowing someone in employment. We need more support, such as mentorship, and we need to direct it in a better, more co-ordinated way. There's always hope but the fact that so many disadvantaged young people are going backwards is really concerning." Greg Craven, the deputy chairman of the Coag council, told Guardian Australia the report was a mix of "good and less good". "If you want a very glass half full view you'll see there are improvements at primary school and year 12 and hopefully they will meet up together at the end of the 10-year reform," he said. "But clearly literacy and numeracy in secondary schools isn't going the way we want and every bad result is particularly bad for disadvantaged young people. Indigenous achievement clearly isn't moving in the right direction."